Traditionally, a borrower of securities, such as a hedge fund, established a prime brokerage relationship with a broker. That borrower of securities entered into various agreements with the broker relating to collateral, margining and payment in return for a variety of services. In an alternative arrangement, a borrower of securities would arrange an account with another broker or in lender of securities.
Once an agreement was established, the borrower of securities phones the broker, or lenders securities, and requests to take securities and give cash. The broker would then call lenders of securities, which may include other brokers and custodial banks, and ask if they are willing to give securities and receive cash. Typically, the broker acts as intermediary, assuming the risk that either the borrower or lender of securities may default on their obligations. If the broker can find securities that the borrower wishes to receive at an acceptable price, then the broker may complete the transaction and moved the securities between the counterparties at agreed-upon date. In return for this service and assuming credit risk, the broker receives compensation from the borrower and lending the security in the form of a spread between the rate of interest paid on the cash from the taker of cash to the giver of cash.
At a later date, the lenders securities may ask for the securities to be returned. In this case, the broker will call the borrower of securities and asked the securities returned the broker for returning to the lender. Also, at a later date, the borrower of securities may asked for the securities to begin back. In this case, the broker will call the lenders securities and formed them that the securities will be returned. Generally, the initial transaction is done for an open settlement date—that is no fixed agreed-upon settlement date. However, in some cases the borrower and lenders may agree on a fix settlement date.
The use of a broker as an intermediary, however, incurs a number of disadvantages from the perspectives of the lenders and borrowers. For example, the broker earns money by maintaining a spread between the lender and borrower, which, if too high, can make certain otherwise desirable transactions too costly to execute. Consequently, it is difficult for lenders and borrowers to know the going fee for the loan of securities. In addition, the broker's access to different lenders and borrowers may be very limited or very slow, thereby making it difficult to find lenders and borrowers of huge number of securities or within a desired amount of time.